Common Stock Valuation
The investor’s required rate of return of 13.5%,
The expected level of earnings at the end of this year (E1) is $6.00,
The retention ratio is 50%,
The return on equity (ROE) is 15% (that is, it can earn 15% on reinvested earnings), and
Similar shares of stock sell at multiples of 16.667 times earnings per share
Questions:
a. Determine the expected growth rate for dividends.
b. Determine the price earnings ratio (P/E1).
c. What is the stock price using the P/E ratio valuation method?
d. What is the stock price using the dividend discount model?
e. What would happen to the P/E ratio (P/E1) and stock price if the company increased its retention rate to 60% (holding all else constant)? What would happen to the P/E ratio (P/E1) and stock price if the company paid out all its earnings in the form of dividends?
f. What have you learned about the relationship between the retention rate and P/E ratios?